The Real Cost of Fiscal Discipline

Ah, somebody is finally spelling out the trade-offs if the world’s developed economies move now to cut government spending or to raise taxes!

This isn’t another one of those exercises that says health care spending and welfare payments will get cut if governments adopt austerity budgets. Really? No kidding. If governments cut spending, governments will spend less?

No, what the World Bank has done is to look at what the effects of different timing for cuts in government spending would do to growth in different parts of the world.

The bank ran two scenarios: One assumed that the world’s developed economies cut budgets quickly—that is, in 2010 to 2014—and the other assumed that cuts would be more gradual—from 2010 to 2020.

Both scenarios assumed that the goal was to reduce the debt-to-gross-domestic-product ratio in developed economies from current levels of 80% to 120% (and higher in a few cases) to 60%.

Not surprisingly, faster cuts result in less economic growth. Compared to slower cutting, the fast-cuts scenario results in a 2014 GDP that’s 1.8% smaller in the United Kingdom, 1.6% smaller in Japan, and 0.9% smaller in the United States.

But because faster budget cuts would reduce the need for government borrowing, interest rates paid by developing economies would be up to three percentage points lower. As a result, the fast-cut scenario that would be so painful to economies in the developed world would by 2014 produce economies 3.4% larger on average for the developing world than if the cuts were phased in more slowly. China’s economy would be 2.9% bigger and India’s 2.3% bigger, for example.

I wonder if German Chancellor Angela Merkel has explained this trade-off to angry German voters. (For more on Germany’s proposed budget cuts and its effect on global economics, see my post.)

Who said virtue is its own reward?

Full disclosure: I don’t own shares in any company mentioned in this post.